California law permits the establishment of a form of business organization called a ‘Professional Service Corporation’ between persons who belong to specified professions, i.e., persons who have a professional license. These include any type of professional activity that may be lawfully rendered pursuant to a license, certification, or registration authorized by the Business and Professions Code, the Chiropractic Act or the Osteopathic Act.

The distinctive characteristic of this form of business is that all the shareholders/members are required to be members of the specific profession. For example, a professional service corporation consisting of doctors and providing medical services can have only duly licensed doctors as its shareholders. The nature of the business is restricted to the services that the shareholder/members are licensed to perform. The name of the corporation requires to be followed by the term ‘Professional Corporation’ or the suffix ‘P.C.’ and should contain the name of at least one shareholder.

Formation

A professional service corporation is formed by filing the articles of incorporation with the relevant authority, adopting the by-laws and drafting the shareholders agreement. The by-laws govern the daily functioning of the corporation, while the shareholders agreement governs the relationship between the shareholders.

Advantages and disadvantages

The primary advantage of establishing a professional service corporation is that it limits liability of the members only to activities that are related to the professional services rendered. Members of a professional service corporation would not be held personally liable for causes of action not related to the service rendered – for example., liability arising out of a slip and fall accident on the premises. However, members would be liable for acts by an employee not supervised by a member. Members also remain personally liable for acts of negligence and professional malpractice of other members. Professionals in California are barred from forming limited liability companies so forming a professional service corporation is less of a choice, but rather the best available option to ensure limited liability.

Another advantage provided by this form of business organization is that may provide some tax advantages and favorable tax treatment in some situations. Professional service corporations may also be able to benefit from better group insurance plans, disability, health and accident plans.

Like corporations, shares held by shareholders of a professional service corporation are freely transferable with one important restriction. They may only be transferred to another member possessing the required license for providing services. For example, shareholders of a professional service corporation providing chiropractic services may only transfer their shares to another duly-licensed chiropractor.

However, it does not come without its disadvantages. Professional service corporations are subject to double taxation – wherein the corporation pays tax on its profits, and the members pay tax on any income/disbursements they receive. While this can be avoided by careful tax planning, it is an important consideration.

The other disadvantage concerns the fact that the professional service corporation is a separate entity. This means, that like a limited liability company, it is required to comply with certain legal requirements. These include conducting annual meetings, maintaining corporate records, maintaining minutes of meetings and the like. A board of directors comprising of the shareholders manage the day-to-day functioning of the entity.

Foreign professional service corporations

Foreign professional services corporations are permitted to establish and operate in California, andare subject to the laws of its state of incorporation. However the professional service is required to be one that is authorized in the California Business and Professions Code for performance by a foreign professional corporation. Reference to a ‘foreign professional services corporation’ here is a reference to an organization incorporated in a state other than California.

The concept of creation of a security interest over real property is popularly understood. Most people take out a loan to purchase a home, and provide the bank with a mortgage over the home to secure the loan. Similarly, it is also possible to create a security interest of personal property. Personal property refers to those properties that are not ‘real property’, i.e., anything that is not land. Personal property could be either tangible – for example, consumer products and automobiles; or intangible – such as intellectual property rights.

The easiest way to understand this would be by taking the example of an installment purchase. Consider this situation: You buy a television from a company called Better Buy by making a down-payment and then make subsequent monthly payments for a specified period. Better Buy has a security interest over the television until you make the last payment. In the event that you default on the monthly payments, Best Buy has the right to seize the television to make good their loss.

This article intends to provide you with a basic understanding of how this security interest is created and how it works. In case you are a lender, understanding this would be helpful in ensuring that you secure your loans.

Creation of a security interest over personal property:

Creation of a security interest over personal property is governed by the Uniform Commercial Code, and requires compliance with certain legal formalities.

Creation of a security interest is done by drafting a security agreement. A valid security agreement should identify the parties, acknowledge and describe the obligation/debt being secured, lay down the terms of repayment, identify the collateral (personal property) and its value, and may specifically grant the lender a security interest in the collateral and the right to repossess upon default. It is sufficient if the security agreement is signed by the debtor alone.

It should also contain the circumstances under which the debtor will be in default.

Perfection:

What happens if there are competing security interests? For example, after buying the television from Better Buy, you borrow $500 from your neighbor so you can buy a cabinet for the television. You sign a security agreement giving your neighbor a security interest over the television to secure the $500 loan. Now there is an issue of competing interests – both Better Buy and your neighbor have a valid security interest over the loan. In case you default on the payment due to one of them, a dispute arises regarding the rights of both parties over the television.

In order to resolve this issue, it is important to ‘perfect’ a security interest.

Perfecting a security interest is a way of establishing its priority over competing security interests, as well as over a trustee in bankruptcy. Generally, competing security interests have priority in the order in which they were perfected, so it is important to perfect a security interest as soon as possible.

The easiest and most common way to perfect a security interest is by filing a ‘Financing Statement’ with the Secretary of State in the state having jurisdiction over the transaction. A valid Financing Statement should contain the identities of all the debtors (including their full addresses), the identity of the creditor or person holding the security interest, and a description of the personal property subject to the lien.

Typically, a Financing Statement is valid for five years from the date of filing. It may be renewed by filing a ‘Continuation Statement’ six months before the expiration. Subsequent to renewal, the Financing Statement is valid for another five years.

The other method to perfect a security interest is by taking possession of the concerned personal property itself. However, this method of perfection is available only to certain kinds of property such as negotiable documents, actual currency, tangible chattel paper, etc. A person may perfect an interest over certified securities by taking delivery of the security.

Amendment and assignment:

In order to continue to be valid, a Financing Statement is required to be amended in the following circumstances: (i) a change or addition of debtors, (ii) assignment, transfer or addition of secured parties, and (iii) addition, subtraction or change in collateral. Amendment is also required in case of a change of address of the debtor.

A secured party can assign his right to receive payment under the Financing Statement to another party by entering into an appropriate contractual arrangement. However, the name of the secured party that appears on the Financing Statement filed with the Secretary of State will be considered the only valid creditor. It is therefore to the interest of the new assignee to arrange for the Financing Statement to be amended immediately.

In case of default:

If the debtor defaults on its obligations under the terms of the Financing Agreement, the secured party may exercise its remedies as stated under the Security Agreement. If the secured party is entitled to take possession of the collateral under the terms of the Security Agreement, it may do so (without breaching the peace). Alternatively if repossession is not possible without breaching the peace, the secured party may approach court and obtain the necessary orders to take possession of the collateral. The debtor is usually held liable for all expenses in connection with this proceeding.

Upon taking possession, the secured party may (i) sell the property and apply the proceeds towards the debtor’s obligation; or (ii) accept ownership of property in partial or full satisfaction of the debtor’s obligation.

In case of competing interests, the security interest that was perfected first takes precedence. If you are a lender holding a security interest, always ensure that the Financing Statement is filed immediately and is up-to-date at all times.

Firemen have an unwritten but clear code of conduct: Do not enter a building on fire, unless you know where the exits are. One of the first things that flight attendants do before take-off is familiarizing passengers on exits in the aircraft. Needless to say, knowing when and how to exit from a sticky situation is the first prerogative of a responsible individual.

Precisely the approach that one must adopt while entering into a Commercial Lease Agreement! With both landowners and tenants looking at ways to maximize returns on commercial property, Commercial Lease Agreements have only become more complex and less transparent over time, particularly in California.

Martire Law has been helping commercial lessees create an exit strategy in their Commercial Lease Agreements. Changes that can happen in the company, industry, or local market cannot always be predicted at the beginning of a lease term. Nevertheless, they must be planned for and negotiated effectively in the agreement.

CC&Rs (caveats, conditions & restrictions) imposed by landowners can be classified into two categories depending on how serious is their long-term impact on the tenant.

Key areas of concern

Some of the areas where tenants have blundered by not properly evaluating lease language pertain to:

‘Use’ of Property: Land owners are known to restrict the lessee’s usage of the property by
having a narrow use clause.
This can limit assignment of the lease, sale of the business,
and diversification prospects over time. A good legal advisor can
help keep the usage options as open as possible, even if the lessee is only seeking “general office use.”

Parking: As companies look at various staffing models such as the use of temps, double
shifts, consultants (vis-a-vis employees)
who do not work full-time, etc, estimating
parking needs in the long run can be difficult. A good legal advisor can help you secure as
much parking as possible, even if it’s not needed, especially if there is no additional fee involved.

Assignment and subletting: A lessee must be able to get out of a lease if the space
is no longer needed; however, a termination
clause may not always be available or may be
expensive. In such a case, subleasing or subletting the property is a good alternative.
Again, subleasing space may not be easy and not knowing how to negotiate it can
turn out to be a costly affair to the lessee.

Relocation and Transition: Negotiating the timeline and costs in order to
avoid delay damages in case the release of the
premise or relocation cannot
happen immediately.

Rights of Recapture and Leaseback: Knowing about exceptions when
the landlords’ right of recapture and leaseback
of a Tenant’s Space must be waived.

Defining ‘Default’: Tenants are expected not to be in default during
the entire lease term. It’s important to define what is
called default and
what the exceptions to the same are.

Profit sharing from subletting/assignment: Negotiation involves limiting
the owner’s profit participation and factoring
various costs borne by the
tenant against the profits accrued.

Liability of Tenant/Assignor & Guarantor: Negotiation involves

understanding the extent of liability, and exceptions that can secure
release from liabilityafter the Lease Assignment.

Renewal & Expansion Options of Tenant

Non-Disturbance Agreements and Signage clauses

With evolution of the business, real estate requirements of companies can change. A good exit strategy can factor this shift, making it a top priority for tenants entering into a commercial lease agreement. Not having such a strategy can be risky to the business, and in worst case cause partial or total closure of its operations.

These are all contracts that, when violated, create a cause of action for breach of contract. When a contract is breached, the plaintiff has to prove that a contract was created in the first place, that the plaintiff fulfilled his role in the contract, that the defendant did not meet their obligations, and that the plaintiff was harmed (damaged) by the breach of contract.

Other causes of action include:

Interfering with an existing contract between two other parties

Interfering with potential of economic gain, which involves a potential contract between two or more parties

California business litigation is a complex arena with its own set of rules. Almost all business disputes include one of these or a combination of the causes of action mentioned above. An experienced business litigation attorney can hear the facts about a dispute and determine which causes of action and statutes apply.

When Fiduciary Relationships Don’t Work

You might see certain cases where business people will enter into special relationships with other business people in whom they place their trust, faith and care. This kind of relationship can evolve into that of a fiduciary. The most common examples of fiduciary relationships are among board members, shareholders, real estate brokers and partners in partnerships. A couple examples of the breach of fiduciary duties include stealing clients, customers or employees or a selfish director on the board of directors who has benefited by self dealing. In the same vein as the contract lawsuit, the plaintiff in this kind of action has to prove that a fiduciary duty existed, that the duty was breached and that the breach caused the plaintiff harm (damage).

Valid and Invalid Fraud Accusations

A fraud case is built around a lie. The lie might represent an intentional distortion of the facts or it might be a cover up for the concealment of information that shouldn’t have been concealed. The plaintiff must in this case prove that he or she actually relied on the misrepresentation, their reliance was justified, and the misrepresentation caused harm. If you knew it was a lie and you went along with it anyway, you can’t sue for fraud.

If a normal and reasonable person would not have went along with it and believed it, you can’t sue for fraud. If you were lied to but were not harmed from the lie, there is no cause for action for the fraud.

These are some of the major causes of action in business litigation. Now that you know what they are, you are ready to work with an experienced business litigation attorney in San Jose. Visit http://www.martirelaw.com/ for more specific information on these causes of action and our practice.

With property transactions, and no matter who you are, if you are a part of the transaction you should always have a lawyer in the case that issues come up that require attention. And if you are going to buy and sell property in San Jose, CA, you need to know about real estate litigation. You don’t often hear about the stories of people who were about to complete a property transaction only to go to court over a dispute with the other party, when the other party changed the terms of the agreement and would not work things out civilly.

Why Real Estate Litigation?

Every real estate venture is an investment. All investors in these ventures must protect their financial interests no matter what the cost. Otherwise they may lose out on thousands of bucks and end up with nothing to show for it all. Don’t be another victim of a bad deal; get a person who is smart, professional and educated about real estate litigation in San Jose

If anything needs to be changed it can be done by an attorney and shown to all parties involved. This will go on until everyone is happy with the changes made in the contracts.

Legal Disputes and the Solution

Problems happen when a contract is disregarded, ignored, misrepresented, or misread. Real estate litigation is the answer to resolving these problems between the parties and completing the transaction.

Property transactions can be confusing even for professional agents because of the laws that surround them. Expert counsel must be taken when it comes to real estate litigation. Issues can even appear when the builder and the commissioner of the builder don’t see eye to eye, and since it’s hard to solve these issues without breaching the contract, more problems and complications can come up. Real estate litigation is an invaluable resource for you to have in your possession.

Lino V. Martire is a San Jose, California real estate attorney with over 20 years of experience representing individuals in real estate transactions and litigation. To make sure you win your case, visit http://www.martirelaw.com/.

Anticipated loss

No legal issue captures the public-private conflict quite like the doctrine of eminent domain, arguably one of the most litigated questions in US constitutional history. Recent legislative and judicial developments in the law on eminent domain in California are testament to the keenness of legislators and judges to clarify and refine the scope and nuances of the doctrine, which has its roots in the Takings Clause of the Fifth Amendment. In this two-part series, we discuss some of these developments, and the impact that they have on the application of the doctrine in California, particularly with respect to the valuation of loss and compensation.

The Fifth Amendment qualifies the Takings Clause – the constitutional basis for the state’s power to seize private property – with (1) public use and (2) just compensation, both of which are crucial to the valid exercise of the state’s eminent domain, and hence inevitably, points of substantial disagreement between private property owners and governmental agencies. With the expansive interpretation accorded to the term “public use” – i.e. the inclusion of “public welfare,” and even the “furtherance of economic development” (Kelo v. City of New London, 545 U.S. 469 (2005)) within its ambit – it is not difficult to foresee the potential for abuse by the government as well as by larger private entities acting in cohort with the government.

It is in this light that the discourse surrounding the issue of “just compensation,” particularly with respect to the valuation of the property sought to be acquired, further highlights the inherent asymmetry in bargaining power between the state and the private individual.

For instance, November 2013 saw a spate of premature suits filed before the California courts, by large banks seeking redressal against an anticipated exercise of eminent domain in respect of mortgages. In both Wells Fargo Bank v. City of Richmond (N.D. Cal., Sept. 16, 2013), and Bank of New York Mellon v. City of Richmond et al. (N.D. Cal., Nov. 6, 2013), the court was presented with two nearly identical cases that sought injunctions restraining the state from exercising its eminent domain in order to refinancing loans which had accumulated balances far in excess of the value of the properties themselves.

Observing that allowing such claims were (a) based on a factual scenario that may or may not eventually take place, i.e. before a dispute had even materialized, and hence (b) absent any imminent, irreparable harm, the court, in both cases, held that judicial intervention in such a case would result in overreach beyond what was necessary to maintain judicial efficiency. Thus, the courts have been unequivocal in mandating that the loss for which just compensation is claimed be “real.” In the aforementioned cases, the judicial determination of real loss hinged on when the loss was incurred; in the following post, we will examine another instance of judicial analysis that leads us to a similar result, albeit in respect of what constitutes “loss” for the purpose of valuation.

This article is the second in a two-part series dealing with the various disclosure obligations that have been recently included in the legal framework governing commercial lease agreements and real estate in California. In Part I, we discussed the disclosures to be made under the amended ADA accessibility regime; in Part II, we will focus on the energy use disclosures required under the Non-Residential Building Energy Use Disclosure Program.

The Non-Residential Building Energy Use Disclosure Program (AB 1103 and AB 531) mandates the disclosure of energy use data (for the prior 12 months), operating characteristics, and ENERGY STAR Energy Performance Score of commercial buildings of over 5,000 square feet, to be made to a prospective buyer or tenant no later than 24 hours prior to the execution of the purchase/lease agreement, and no later than the submission of the loan application in the case of a prospective lender. Since July 1, 2013, the program has been in force with respect to buildings of over 50,000 square feet, however the same is slated to come into effect on a staggered basis and will cover buildings over 10,000 square feet by January 1, 2014, and those over 5,000 square feet by July 1, 2014.

Indeed, this mechanism is not unknown to realtors and the administration – since January 1, 2009, gas and electric utilities have maintained energy consumption data for all commercial (non-residential) buildings, which have been uploaded to the United States Environmental Protection Agency’s ENERGY STAR Portfolio Manager portal on a consent basis. However, the program now mandates the usage of the free online portal, which requires utility account-holders to furnish data within 30 days of each request. Additionally, the user is also required to fill out a compliance report and download and make available certain “Energy Use Materials” (Disclosure Summary Sheet, Statement of Energy Performance, Data Checklist, Facility Summary) to prospective tenants and buyers.

The software tool compares buildings located in regions experiencing similar climate and operational conditions, and scores them relatively on a 1-100 scale – a rating of 75 qualifies for ENERGY STAR certification – allowing prospective tenants and buyers to estimate future operating costs, rather than mere utility bills, when comparing buildings. At the same time, maintenance of the ENERGY STAR profile and rating is an additional burden on the real estate developer, given the degree of influence it can have over potential customers.

This system is an improvement on the benchmarking system to aid tenants, buyers, and lenders to compare energy consumption data of similar commercial buildings that was created in 2007 pursuant to Section 25402.10 of the California Public Resources Code. Moreover, it must be borne in mind that these disclosure obligations apply specifically to sales, purchases, or financing agreements in respect of an entire building, and not portions of buildings, or to multi-family buildings.

Though no sanctions have been specified for the failure to comply with the above mandated disclosures, it is certainly in the interest of real estate developers to take these regulations seriously, when dealing with clients, who will almost certainly require evidence of compliance as a prerequisite to the closing of a real estate transaction, thus creating a self-regulating market, that significantly reduces the burden of enforcement on the state.

Senate Bill 1186 – Accessibility

Over the past several months, the legal and regulatory framework applicable to California commercial lease and rental agreements has undergone major legislative changes, some of which are already in effect. In the following two articles, we will discuss the two most important amendments – Senate Bill (SB) 1186 and Assembly Bill (AB) 1103/531 – each mandating the inclusion of additional disclosures, pertaining to accessibility and energy use respectively, in certain categories of lease agreements.

Perhaps no case illustrates the importance of the pre-legislative process and sound statutory drafting better than California’s tryst with the Americans with Disabilities Act (ADA) and related state accessibility legislations. In the past few years, over 14,000 ADA lawsuits have been filed in California alone, with some statistics attributing over 40% of all ADA lawsuits filed to the Golden State, despite it having the highest overall ADA compliance in the country. In an effort to curb such predatory litigation and abuse of court process, while simultaneously incentivizing ADA compliance in commercial establishments, the California State Legislature enacted SB 1186 in September 2012, which imposes stricter procedural obligations on plaintiff’s attorneys litigating on such accessibility laws, and offers additional protections to businesses faced with such litigation.

SB 1186 requires all commercial lease agreements executed on or after July 1, 2013 to disclose: (a) whether the subject-matter property had been inspected by a Certified Access Specialist (CASp) (any person certified under Section 4459.5 of the California Government Code), and if so, (b) whether or not the property has been determined to be in compliance with the accessibility standards notified under California Civil Code Section 55.53. As per the advice of the California Commission on Disability Access, this requirement may be applicable to certain commercial lease agreements entered into prior to July 1, 2013, in so far as the same has been amended or renewed on or after this date, or buildings that are the subject matter of pre-existing leases, but which are being sold or financed after July 1, 2013.

While the amendment makes neither the CASp inspection nor compliance with Section 55.53 standards compulsory, and simply mandates disclosures in these respects, lessors who can make both disclosures in the affirmative may argue for certain protections – such as preliminary stays on ADA lawsuits (and hence, the opportunity to correct accessibility issues and dismiss the lawsuit), as well as reduced statutory damages, provided that the violations are cured within 30-60 days of the complaint (depending on the size of the business). At the same time, the legislature has been careful to ensure that a negative statement in respect of a CASp inspection is inadmissible as evidence of “lack of intent to comply with the law” (California Civil Code Section 55.53(f)).

The inclusion of this disclosure is slated to become a contentious point during the lease agreement execution process, especially since both landlords and tenants have been held to have concurrent ADA liability (Botosan v. Paul McNally Realty (216 F.3d 827 (9th Cir. 2000)), leading to several tenants being named as defendants in accessibility lawsuits. For small business tenants (commercial space of 7,500 square feet or less) operating out of San Francisco, the San Francisco Administrative Code Chapter 38 titled “Obligations of Landlords and Small Business Tenants for Disability Access Improvements,” which came into force on June 1, 2013, supplements these protections by ensuring that commercial lessors make appropriate disclosures as to the accessibility-condition of the rental space.

Thus in addition to the existing burden of negotiating which party will be required to bear the cost of compliance, parties will now have to undertake a cost-benefit analysis of the CASp inspection, and determine whether the cost of the inspection outweighs the cost of compliance in every case that arises – for instance, the cost of installing ramps, widening doors, designating special parking space, adding Braille markings on elevator buttons and signs, installing accessible bars isn toilets, and replacing certain types of carpeting inter alia. Nevertheless, given the propensity of ADA litigation in California, parties may, more often than not, find it beneficial to conduct the inspection in every case, and avail of the additional protections provided by SB 1186, which thus creates an important item in the commercial real estate due diligence checklist.

Inclusionary housing ordinances in counties and cities across the United States have been enacted to address the affordable housing needs of the region while promoting effective economic integration. Indeed, the California affordable housing program has been one of the most successful in the nation, yielding over 10,000 affordable housing units, as opposed to states such as Massachusetts that are yet to produce even one.

In the wake of the housing bubble, an acute shortage of affordable housing in upmarket San Jose, California prompted a spate of executive action, most notably San Jose’s inclusionary housing ordinance in 2010. Slated to come into force in January 2013, the municipal housing ordinance mandates that (a) 30% of residential development projects of 20 or more units be made available at varying below-market rates, as per the notified pricing slab, or (b) such affordable housing be constructed at a different location as a proportion of the total project, or (c) an “in-lieu” development fee, equal to the surplus of the median market price (over the past 3 years) over the government-specified market rate, be paid into the city affordable housing fund.

However, the legality of this particular ordinance is currently sub judice in the appeal against the decision of the Sixth District Court of Appeals in California Building Industry Association v. City of San Jose ((2013) 157 Cal.Rptr.3d 813) pending before the California Supreme Court expected to have far-reaching implications on similar ordinances promulgated throughout the state of California in 2014. The bone of contention that emerges from the controversy is whether this ordinance, which compels the real estate industry to provide affordable housing, amounts to an arbitrary allocation of a societal burden of the state.

In the various cases in which the validity of these ordinances has been considered, three rationales emerge, with the judiciary having overturned validity on two of those grounds in two of the very first successful challenges in 2009. In Palmer/Sixth Street Properties v. City of Los Angeles (175 Cal. App. 4th 1396 (2009)), (where the court invalidated the ordinance in respect of rental units as violative of a lessor’s freedom to set initial rent under a rent “de-control” legislation) and Building Industry Association of Central California v. City of Patterson (171 Cal. App. 4th 886 (2009)) (where the court characterized the aforementioned “in-lieu development” fee to escape compliance with the ordinance as an exaction which failed the “reasonable relationship” test) the judiciary used very different analyses – rent/price control and exactions, respectively – to arrive at the same fundamental result.

Furthering the line of reasoning adopted in Patterson, the jurisprudence on the California Mitigation Fees Act 1987 that invalidates such “in-lieu development” fees as being “exactions” was reaffirmed by the California Supreme Court as recently as October 2013 in Sterling v. City of Palo Alto (Cal. S. Ct. No. S204771). The verdict followed the June 2013 ruling of the United States Supreme Court in Koontz v. St. Johns River Water Management District (568 US ___ (2013)) where the Court held that the land use ordinances imposing such fees would have to survive the nexus test of “rough proportionality” between the exaction and the impact of a proposed development.

The controversy was further heightened when the California legislature unsuccessfully attempted to reverse the result of Palmer and Patterson through the passage of Assembly Bill 1229, which would accord statutory backing to these inclusionary housing ordinances. However Governor Brown vetoed the Bill, given that the matter is still pending before the California Supreme Court, and until then, Palmer and Patterson continue to hold as good law.

It remains to be seen whether the California Supreme Court’s opinion in San Jose will bring closure to this legal controversy, and whether it will choose to overrule or reconcile its decision with Palmer, which specifically applies to “rental” projects, and is not based on the “exactions” rationale.

If recent trends of the California Supreme Court are anything to go by, commercial real estate agents may have to be more careful about what they say when entering into lease agreements. In January 2013, the California Supreme Court in Riverisland Cold Storage Inc. v. Fresno-Madera Production Credit Association (2013 WL 141731 (2013)) reversed an 80-year old rule limiting the admission of extrinsic evidence (including oral evidence) to show that a contract was tainted by fraud, essentially opening the floodgates of litigation to a bare claim that would have otherwise found little favour with the court – “I never read the contract before signing it; they told me it said something else and so I did.”

The parol evidence rule, as codified in Section 1856 of the Code of Civil Procedure, and Section 1625 of the Civil Code, precludes challenges to the validity of an “integrated contract,” or one which the parties expressly intend (by the inclusion of an integration clause) to be the final expression of their agreement, on the basis of prior written or oral agreements and contemporaneous oral agreements; this rule, however, is subject to a number of codified exceptions, one of which is fraud.

The prevailing law in California prior to Riverisland was laid down in 1935 in Bank of America v. Pendergrass (4 Cal.2d 258, 263 (1935)), where the Court rejected the claim advanced by borrowers who had restructured their debt after defaulting on payments, that the lending bank had made oral representations contrary to the terms of the written agreement, to the effect that the renegotiated agreement would extend the period of the loan, in order to fraudulently induce them to put up additional collateral. In doing so, the Court refined the fraud exception, expressly excluding facts evidencing “a promise directly at variance with the promise of the writing,” and upholding its application solely in instances where the evidence sought to be admitted was an independent fact or representation evidencing either a fraud in the procurement of the instrument or a breach of confidence with respect to its use.

Since then, California creditors and mortgagees have enjoyed the protection of this peculiar rule that has prevented debtors from relying on oral statements made prior to or at the time of their entering into the contract, placing the onus of due diligence squarely on the shoulders of the contracting parties. In Riverisland, which presented facts virtually identical to those of Pendergrass, the California Supreme Court seized opportunity to correct what was widely considered an 80-year old mistake, terming its decision in Pendergrass an “aberration” that ran contrary to the statutes, restatements, and prior case law, in addition to constituting bad policy.

In its attempt to bring California law in conformity with the laws of the majority of the other states, however, the language of the court’s decision creates no safe harbours that would preclude fraud claims even in cases where both parties have carefully read the clauses of the contract, in contrast to the case in Riverisland, where the parties relying on the oral representations were uneducated. This will undoubtedly have significant ramifications on the climate for contract formation in California, even if the various other elements of fraud (knowledge of falsity, intent to deceive, reasonable reliance, and resulting damage) are difficult to prove. Indeed, leasing agreements have become some of the first victims of newly-expanded fraud exception to the parol evidence rule, with the Court ruling in favour of tenants who alleged fraud despite having read and renegotiated lease agreements in both Julius Castle Restaurant v. Payne (157 Cal. Rptr. 3d 839, Cal. App. 1st Dist. (2013)), and Thrifty Payless, Inc. v. The Americana at Brand, LLC (2013 WL 3786374 (2013)), as recently as July 2013.

While the inclusion of more robust and conspicuous integration clauses that evidence clear intention on that part of the parties to supersede any oral promises, in addition to clauses that express that the agreement has been jointly drafted with recourse to legal representation, may afford some protection, it remains to be seen whether such contracts will survive judicial scrutiny, given that the court has gone so far as to distinguish such cases from precedent that precludes challenges to validity where the party alleging fraud was negligent in acquainting himself with the terms of the written agreement despite having had reasonable opportunity to do so, as applicable only to the execution of the contract rather than its formation (Rosenthal v. Great Western Financial Securities Corp. (14 Cal.4th 394, 419 (1996)).

Indeed, the decision in Riverisland appears to have heralded the return to a position of law which had been historically evolved in the 1800s to protect the interests of mortgagors at a time when mortgage agreements were drafted so as to convey title to the mortgagee immediately, subject to the timely payment of a consideration (Pierce v. Robinson (1859) 13 C 116). However, in light of changing circumstances and norms in contract formation, a legislative clarification of the law in a manner that reflects a balancing of the freedom of contract and its policy interests in protecting small parties, is essential to preserving California’s environment as conducive to contractual relations.